I recently attended a small presentation given by the CIO of one of Oxbridge’s college endowments. He was a typical economist – articulate and confident in his views, with some big-brand names on his CV and a reassuringly expensive suit (he must know what he’s talking about). In typical economist style, he also threw out “cautiously optimistic” statements abound, predicted 40% chances of events happening (the oldest trick in the book), and gave no idea about how accurate his past forecasts had been (which should be the first slide in any economist’s presentation, in my opinion).
When asked by a member of the audience why his portfolio was so overweight to UK-equities, and why he had such a heavy underweight to ex-UK, he replied that, “while the companies we own are predominantly UK-listed, they’re all global companies with global revenues, and hedge all the currency exposure for us.”
It’s an incredibly common belief that investing in your local market can give global exposure. Investors will typically be investing in the largest local companies, the vast majority of which, due to their size, receive revenues from all over the world. By investing in companies that investors can buy in their local currency, there’s also no need to incur FX costs or incur hedging costs.
While our economist wasn’t wrong that many of the largest UK companies generate most of the revenues from overseas, is that a good argument for neglecting overseas companies in your portfolio?
The points that follow are applicable to all countries, but let’s assume that we’re a UK-based investor and our local index is the FTSE 100 (the FTSE All-share is probably a better representation of all UK-listed businesses, but given the ubiquity of the FTSE 100, let’s use that).
Does the FTSE 100 provide enough diversification?
Let’s start by thinking high-level. By investing in the FTSE, you’re only getting exposure to one country’s companies. Yes, the revenues from those companies might come from all over the world (more on that in a moment), but you’re limited to the companies listed in the UK. The dangers of only investing in one country’s companies can be significant.
In the fifty years to the end of 2011, the Italian stock market delivered an annual real return of -0.8% per year. That’s a negative real return over 50 years – a truly abysmal return. By contrast, bonds returned 2.64% per year in real terms. In Germany, equities rose 3.46% per year in real terms over the same time frame, again losing to bonds which returned 4.28% a year. And in Japan, the market still hasn’t recovered to reach its previous high in 1989.
We might reasonably believe that the UK market is always likely to avoid a long period of stagnation. The UK is a well-developed market, has a strong economy, corporate governance, regulations, and relatively free movement of labour and capital. But why take the risk?
By limiting our investments to one country, we’re running the risk that the country we invest in suffers the same fate of Italy, Germany, or Japan.
In addition, it’s a source of uncompensated risk – by taking the extra risk, we’re not getting any additional return. And it’s a risk than can be easily mitigated through global diversification.
Now let’s look at our revenue exposure. By investing in the FTSE 100, are we diversified by currency? When I say, “diversified by currency”, I mean, “are our returns too dependent on the moves of any single currency”?
Companies in the FTSE 100 derive approximately 75% of their revenues from overseas, meaning that a FTSE investor is heavily exposed to foreign currency fluctuations. When sterling depreciates, the FTSE does well, and when sterling appreciates, then it does badly.
On the face of it, this looks like we’re heavily dependent on the moves in sterling, so aren’t diversified by currency.
But this is effect is mitigated to some degree by the causes of currency fluctuations. A currency strengthening or weakening is usually an indicator of changes in a country’s expected economic health. A country’s currency strengthens when there’s positive news for the economy, and the currency weakens when there’s negative news. When the companies in that economy derive most of their revenues from overseas, the effects work in opposite directions. For example, bad news coming out for the UK’s economy would hurt UK-based business (bad for the FTSE), but would weaken sterling, which would be good for those companies who earn their revenues from overseas (good for the FTSE).
In terms of whether you’re diversified by currency – it’s hard to say. Given that the heavy exposure to sterling in the FTSE means any strength in the currency hurts performance, the effect is moderated by the fact that the cause of the strength usually indicates good news for the underlying businesses.
Now let’s turn to sector exposure. If we invest in the FTSE 100, are we diversified by sector?
The graph below shows the weights of all the sectors in the FTSE 100 vs the S&P 500 vs the MSCI World:
While the FTSE does have exposure to all sectors, some are much more heavily weighted in the index than others. By investing in the UK, you’re getting almost no technology exposure – technology companies only make up around 1% of the FTSE. If you compare that to the technology weight of the MSCI World, around 17%, that’s a significant underweight. In contrast, energy companies make up a relatively large 15% of the FTSE 100 versus around 5% for the MSCI World.
By investing in the UK market, you’re making sizable bets that tech as a sector will underperform, and that energy will outperform. Unless you have signification conviction in those opinions, it makes sense to be more diversified by sector.
On the other hand, if you’re a US investor investing only in the US, then you’re making the bet that tech will outperform – a weighting in the S&P of 23% vs the MSCI World at 17%.
Depending on what your local market is, you could be taking some pretty significant sector bets by overweighting your domestic index.
How confident are you that the stocks in your local market are going to be the top performing stocks in the future?
Thinking logically, how likely is it that the best performing companies happen to be listed in the place where you were born? By overweighting your local index, you’re taking a bet that the companies that happened to be based on the spit of land where you grew up will do better than those companies everywhere else in the world.
If you’d been born somewhere else, your portfolio would likely look different. Excluding currency considerations, does that make sense? Wouldn’t you want to invest in the same companies no matter where you happen to be born, or happen to live at any point in time? If you moved from the UK to France, would you want to change your portfolio from investing in the FTSE to investing in the CAC? It doesn’t seem to make much sense that what defines a “good” company depends on where you live.
If we look at the global sector weightings, we can see that the UK is a tiny part of the global market:
The UK only makes up 6% of the MSCI World. If your UK allocation makes up more than that, you’re making the implicit bet that UK companies will do better than the those based in other countries. Are you that confident?
Investing in our local market feels safer. Often, we feel like we know more about the companies in our local stock market because we interact with them frequently. We all know what Barclays, EasyJet, ITV, and Sainsbury do. “Invest in what you know” is an often-quoted investing mantra, but how much do we really know about these companies, other than the fact that we buy their products? And is simply knowing the companies a good enough reason to exclude others?
By only investing in companies who you’re familiar with, you’re excluding most companies in the world. And the chances are that, given only 1% of stocks create 99% of global wealth, the ones in your local market won’t be the ones generating those long-term returns.
By foregoing international companies, you’re increasing the risk that the country’s stock market performs poorly, you’re making some significant bets on which sectors will outperform, and you’re reducing the chances that you’ll own the very few companies which generate the vast majority of long-term stock market returns.
In addition, while investing in one country is an increase in risk, it doesn’t come with a commensurate increase in return. You’re taking uncompensated risk – which is the kind of risk you never want to take. What’s more, it’s a kind of risk which can be easily mitigated through diversifying into markets in other countries.
So in theory, no, investing in only the FTSE 100 doesn’t give you sufficient diversification.
“But what about the evidence?” I hear you ask. To answer that, the next series of posts looks at the evidence for and against international diversification.